WHY INVESTORS MISJUDGE THE ODDS Knowing the mental pitfalls may help you avoid them -- and lead you to some buying opportunities.

By JOHN J. CURRAN REPORTER ASSOCIATE Constance A. Gustke

November 2, 1988

(FORTUNE Magazine) – THE FINANCIAL world, as any weather-worn veteran knows, is a muddle of risk and opportunity. Separating the two is not always easy. All too often,
investments beckon with the promise of princely rewards, only to begin croaking like frogs after you plunk your money down. Other securities that seem repellently risky wind up
showering wealth on their owners. How is it that investors are so woefully inept at perceiving risk? One reason: People tend to view risk through warped intellectual lenses,
repeatedly seeing hazards where they don't exist or overlooking those that do. A devoted band of psychologists and other experts have plumbed and catalogued these flaws; knowing about
them can save you a lot of grief -- and maybe some money as well. High on the list of mental quirks is the human tendency to give great weight to easily recallable experiences when
trying to divine what will happen in the future. These experiences can temporarily make people foolhardy or cowardly. Think back to the big box office hit Jaws. Pretty terrifying
stuff, no? Now, be honest. After seeing that movie about killer sharks, weren't you just a little more nervous the next time you waded into the surf? And how about the last time you
saw the horror of a big jetliner crash on the TV news? Weren't you just a tad more squeamish the next time you booked airline reservations? The explanation for such irrational
responses to a horror movie or headlined disaster is a phenomenon psychologists call availability. As the word suggests, people tend to base their forecasts on events that are most
available to their memory. Alas, they give so much weight to recent experience that they ignore solid evidence to the contrary. There has been no real increase in the danger of shark
attack, and the odds that your plane will go down in flames do not rise because a crash has just occurred. Irrational responses are harmless enough at the beach or airport. But when
they distort investment decisions, the cost in missed opportunities to buy cheap stocks can be enormous. No big-screen thriller lives more vividly in investors' memories these days
than the free-fall drop in stock prices last October. In sweeping away billions of dollars of wealth, the crash left behind an unforgettable image of panic and fundamentally altered
attitudes about stocks. ''There is tremendous fear in the market right now,'' says David Dreman, president of Dreman Value Management, a leading contrarian investment firm. He has
scored his biggest wins by capitalizing on the psychological mechanisms that lead people to shun securities and let their prices slide to bargain levels. Right now, Dreman maintains,
fear is keeping investors on the sidelines. The risk of another market rout, he says, is much lower than it was last year. But the memory -- or availability -- of the 1987 crash makes
people timid beyond reason. Says Dreman: ''There's plenty of good value in the market now. Stocks are selling at 12 times expected 1988 earnings, down from the astronomical
price/earnings multiples of last year. But few people are interested.'' It's not the first time a big scare has turned investors lily-livered for a long spell. Small-capitalization
stocks, those of small and medium-size companies whose total outstanding shares have a relatively modest valuation, collapsed in mid-1983. Led over the brink by high-tech companies,
small-cap stocks fell 28% in nine months, scarring many investors' psyches. Five years later people are still reluctant to venture into this sector of the market. ''The 1983 collapse
was a fireworks display on the risks of small- capitalization stocks,'' says Hersh Shefrin, a professor of economics at Santa Clara University. ''The aftereffects will take some time
to wear off.'' FOR INVESTORS who can see past the illusion of high risk, opportunity waits. By time-tested yardsticks, small-cap emerging growth companies are selling at their most
attractive level in years. Roger McNamee, a portfolio manager at T. Rowe Price's New Horizons Fund, calls this ''a table-pounding buy signal for small stocks,'' but adds that ''people
are still too frightened to act.'' At other times, of course, folks can be in a daredevil mood. During the seemingly unending rise in the broad market indexes before the crash,
availability worked in a different way on most investors, prompting them to cling to stocks that were dangerously overpriced. All sorts of warning signals were flashing red: In
mid-August 1987, stocks were selling at nearly three times book value per share and at an average P/E of 22. Yet many investors went on buying at absurdly inflated prices. Paul
Andreassen, a professor of psychology at Harvard, has delved into the ways people decide whether a trend, such as rising stock prices, will continue or reverse. He has observed that
even professional money managers, influenced by an effect akin to availability, can be seduced into believing that a trend will go on forever. The process of seduction, Andreassen
notes, usually takes place over time, as investors begin to reshape their view of what is normal for stocks. ''People believe that something is normal and therefore sustainable as
long as it resembles what existed in the recent past,'' he says. The critical variable, he adds, is how people interpret the past. In the stock market, people usually sum up the
recent past in terms of prevailing prices. Over the very long term, stocks on average have sold at about 12 times earnings and somewhere between one and two times book value per
share. If the market heads much higher or lower than those historical averages, rational investors would normally expect a reversal. But what if the market's rise continues over a
long period, as it did during the five years beginning in August 1982? Andreassen finds that people will begin to reshape their view of the past -- and of the future. ''Faced with a
long series of positive changes,'' he says, ''people will stop summarizing the past in terms of price levels and instead will summarize it in terms of price changes.'' Accordingly,
what people used to hold as the norm for stocks -- a P/E of 12, a price-to-book-value multiple of less than two -- ceases to matter. Their new idea of what is customary for stocks
comes to approximate the recent rate of change in stock prices: compound annual growth of 26% over the five-year bull market. Says Andreassen: ''If stocks keep rising long enough,
people eventually come to believe that that is the normal state of affairs, and that it can go on for a long time.'' Thus, otherwise sane investors marched over the cliff last
October. EVEN IN THE subdued post-crash atmosphere, people can take a fatuous view of certain favored stocks. David Dreman believes that many analysts and investors are currently
overpaying for cyclical stocks, such as steel and chemicals, because they assume that the recent trend of explosive earnings gains will continue. ''It's almost as if they believe that
the cyclicality has been taken out of cyclical stocks,'' he says. Dreman believes the cyclicality of earnings will return with a thud in the next recession and the stocks will tumble.
Foolish investment moves can also result from something psychologists call anchoring. Any number that has just been put in your head weighs heavily, whether relevant or not. Think
you're immune to such a foible? Think again. Psychologists Amos Tversky at Stanford University and Daniel Kahneman at the University of California at Berkeley, two leading researchers
in the psychology of decision-making, enlisted their students in a simple test of anchoring's diabolical drag. Different groups were asked to guess what percentage of African nations
belong to the United Nations. Before answering, one group of students was given an arbitrary reference point of 10% -- arrived at by spinning a wheel of fortune in the students'
presence. The students were asked to say whether their answer to the question was above or below the number on the wheel, and by how much. Average guess: 25%. A second group, unaware
of the first group's response, was given a higher starting point of 65% on the wheel. Here the guesses averaged 45%, significantly above the first group's. The higher reference point,
the psychologists say, influenced the higher numbers. Surprising as it may seem, this anchoring bias has been confirmed in numerous tests dealing with all sorts of questions. Says
Tversky: ''It's hard to think fresh because your mind is contaminated by those aforementioned values.'' The same thing can happen with information that bears on investing. For
example, the long-term average growth rate of the GNP has a powerful pull on some economists' forecasts. David Levine of the Sanford C. Bernstein brokerage firm believes his fellow
economists often miss the mark because they anchor their prediction of next year's GNP growth to the long-term average, making only minor adjustments up or down. Says Levine: ''What
economists often fail to see is that the historical average results from many quarters of far-above- average growth as well as from many of far-below-average growth.'' As a
consequence, he thinks, many economists are underestimating the power of the current economic expansion. In the stock market, investors are confronted with whole flotillas of numbers
tethered to anchor chains. The most prevalent examples are security analysts' forecasts of companies' earnings per share. A company's profit growth in the preceding year has a heavy
influence on what the Street projects for the forthcoming quarters. INVESTMENT decisions are twisted by yet another gremlin: our willingness to draw big conclusions from a small
amount of data. Psychologists say that people rely all the time on a mental shortcut called representational data. Latching on to one characteristic of something, they lump anything
else with this characteristic into the same category. The thought process is part of your survival instincts: You are followed down the street at night by a man in shady dress. You
don't quiz yourself on the statistical odds that he is a criminal. You have seen one representative characteristic -- his attire -- and that is enough. You cross the street to avoid
him.

But representational data can lead to serious misreadings of a situation. The man may not be a criminal at all. Similarly, a blindfolded person who grabs an elephant's tail may well
conclude that he's holding a snake if he uses only representational data, i.e., the tail. In the financial markets, investors' heavy reliance on representational data has recently
created some rare buying opportunities. Analysts say that many top-quality banks and savings and loan associations have gone begging because they all wear the same ''troubled
industry'' label, even though some have problem loan portfolios while others are financially strong. Analysts say the stocks of healthy banks and thrifts, such as BARNETT BANKS of
Florida or H.F. AHMANSON, a California S&L, are undeserving wallflowers. One firm that looks to capitalize on these recurring investor biases is Concord Capital Management of San
Mateo, California. Hal Arbit, the firm's president, constantly scrutinizes the market to see where investors have overestimated risks. He finds fertile ground in industries where
investors focus on one key indicator of health, such as the book-to-bill ratio in the semiconductor industry or the percentage of seats filled on airlines. These representational
data, he says, are frequently off the mark. Says Arbit: ''These are usually good indicators of an industry's health. But at times they can seriously mislead people.'' The trucking
industry offers a recent example, Arbit says. The key indicator of profitability is something called the less-than-full truckload rate. This tells how much a trucker is able to charge
for unused space when a customer's load fills only part of the truck. Often it's a fair indicator of pricing strength in the trucking industry. But lately, Arbit notes, institutional
investors have dumped truck stocks because the indicator is sending out negative signals. ''This indicator is leading investors to believe that risks are increasing in this business
when, in fact, they are actually about to decrease,'' he says. By Arbit's calculations, the long-term squeeze on profitability in trucking is about to force out some marginal players
who helped bring on the price slashing. Once they are gone, the surviving truckers with well maintained fleets, like YELLOW FREIGHT SYSTEM, ROADWAY SERVICES, and CONSOLIDATED
FREIGHTWAYS, should prosper. THE FAMILIAR failing of overconfidence, psychologists say, also distorts investor behavior in insidious ways. Here overconfidence is more than just the
usual suspender-snapping belief in one's ability to figure things out. It is a tendency to overestimate the precision of thought processes. Says Tversky: ''People in general are much
surer of the validity of their conclusions than they have any right to be.'' The dramatic effect that overconfidence can have on investment results was investigated more than a decade
ago by a group of petroleum engineers working for Atlantic Richfield. They noticed the consistent tendency of bidders for oil drilling rights to increase the risk of a poor return by
bidding too much for the rights. This stemmed from overconfidence in their analysis of what the potential oil reserves were worth. The engineers called this recurring problem the
winner's curse. To understand how this works, assume that some drilling rights are put up for bid to a dozen oil companies. In economic value, the drilling rights are worth the same
to each bidder. Naturally each oil company does its own evaluation of the site. Some estimates are above the real value of the tract and others below it. When the bidding is over, the
firm that wins the rights will usually be the one that went into the bidding with the highest estimate of what the reserves were worth. Because the estimate was the highest, there's
also a very good chance that it was above the true value of the reserves. The overconfidence that prompts overbidding is not unique to the petroleum industry. It results from people's
penchant for placing great weight on what they know -- their own valuation of something -- and almost no weight on what they don't know. Thus, they are prone to overestimate their own
knowledge of something and underestimate the possibility that they might be wrong. Notes Tversky: ''Research shows that when an expert says he's 90% sure, he's correct only 60% of the
time.'' The reasons for this unfounded confidence, says Tversky, trace back to the way the mind functions: ''Basically, the mind is not designed to assess what we do not know. It is
designed to find explanations for things, and then find support for, and build confidence in, those hypotheses.'' OVERCONFIDENCE infects investors too. It leads them to focus too much
on why they like a stock or bond, and to ignore the reasons that others don't. Every time you buy a stock, you're getting it from someone who no longer finds it an attractive
investment. The next time you prepare to buy a stock, it's worth asking yourself why the sellers don't perceive the same value that you do. The answers may not change your mind about
buying, but they may make you wait for a lower price. Can investors be taught to suppress these psychological biases? Tversky doubts it. Such mental shortcuts as anchoring and
representativeness, he says, ''are the very building blocks of intuitive reasoning. You can't do away with them.'' The best that people can do is to be aware that their intuitive
reasoning can result in error, and to examine thoughtfully the reasons behind a decision. Tversky's advice: ''Try to be a little more critical. Because something looks a certain way
does not mean it is that way.'' That wisdom may not make you rich, but it could keep you from being rash.